On June 6, the European Central Bank (ECB) communicated its decision to lower its three main interest rates by 25 basis points for the first time in five years.
Ahead of the Fed, which by tradition, would have been expected to come forward first with an interest rate cut, the ECB brought its main refinancing rate down to 4.25% from 4.50%.
Concurrently, the marginal lending facility rate and the deposit facility rate decreased to 4.50% and 3.75%, respectively. But why now, and what does it mean for the Euro area?
More context
Lest we forget, the world’s central banks hiked interest rates to rein in the high inflation elevated by the pandemic and the energy shockwave stirred by Russia’s aggression against Ukraine.
Prices in the Euro-dependent economies, the US and the UK soared as a result, eroding buying sentiment and causing investors to pivot to safe-haven assets such as gold or silver.
Since then, the situation has broadly improved. Although some prices continue to rise, particularly in the services sector, overall inflation has declined, giving a breather to the business sector and reinvigorating investor interest for alternative assets.
Despite the progress it made in taming inflation and bringing it closer to its 2% target, the ECB is still not rushing to continue dropping the interest rates. This stance has been perceived by many as “hawkish”, since the central bank remains committed to keeping “interest rates restrictive for as long as necessary”, whilst pursuing “a data-dependent and meeting-by-meeting approach”.
The immediate impact on the Euro
The monetary policy divide between the US and Europe has slightly weakened the Euro. If between mid-April and mid-June, the single currency had strengthened against the US dollar, rising to 1.070 from 1.062, now considering the asynchronous monetary policy between the ECB and the Fed, the Euro could face further devaluation against the dollar.
Why is the Euro weaker?
There are at least three reasons behind the single currency’s weakness. First, the imperative to boost European production and exports, especially in the field of energy has never been more evident as the Ukraine war has been dragging on for nearly two years, driving energy costs at record highs.
Unlike the US, for example, which is the world’s largest energy producer and consumer at the same time, the EU has yet to catch up on production.
Still largely dependent on Russia’s fossil fuels, the EU has a lot more to suffer from the high energy prices than the US, which is well known for its ability to offset any losses in purchasing power as an energy consumer against the gains it generates as an energy producer.
It may be quite some time before Europe reaches its green energy target and breaks the shackles of fossil fuel dependency. This brings us to the second reason - the US dollar strength.
The Federal Reserve has already hiked its key interest rates three times this year. Huge amounts of cash started flowing into the US economy to benefit from the higher interest rates. In keeping with the old adage, “higher interest rates, greater demand for currency”, the greenback appreciated thanks to greater demand.
The third reason is more related to the markets’ reaction to the current economic context. As explained earlier, in times of uncertainty, investors tend to shift focus to what they consider as safe havens.
Presently, the US dollar is the only global currency and hence, it serves as a universal means of exchange for goods and services worldwide. This contributes to it being regarded as a safe haven, which makes it appealing to investors.
Nevertheless, caution must be exercised and investors should continue to stay informed about the markets and assess risk according to the fundamental and technical data at hand.
Are there any positives to a weaker Euro?
The weaker Euro has as many significant advantages as it has disadvantages. The first and foremost advantage is the rising cost of exports. European products - priced in US dollars - become more affordable in the US, which, in turn, boosts demand for EU goods instead of locally produced, similar, more expensive products.
Rippling down into the EU economies, higher export demand will encourage European companies to produce more goods and services. In doing so, they create jobs, hire additional workforce, and increase their supply chains. Thus, higher exports have a vital impact on the domestic economy, causing it to expand.
However, the positive effects of a weaker single currency are counterbalanced by negative aspects.
Negative effects of a weaker Euro
The reverse of increased exports is the higher cost of imports that are paid for in US dollars. This does not apply only to final goods but also to raw materials priced in US dollars, meaning that EU consumers will pay more for US-imported goods.
Gradually, this erodes consumer confidence and hurts demand. European companies will therefore need to brace themselves for lower demand, which could lead to an economic downturn.
On the flip side, the higher prices for imported goods could also work positively for companies in the eurozone. As US products become more expensive, Europeans will eventually turn to similar European products providing better value for money. This stabilises production and employment in the Euro area.
Notwithstanding that, delaying to cut interest rates by the Fed will only widen the gap between key interest rates in the EU and the US.
Meanwhile, the key takeaway for traders and investors is to educate themselves about the markets and macroeconomic events such as the ECB and Fed monetary policy decisions. Staying abreast of key economic events and data releases can help them make better-informed decisions during times of upheaval.
By Marios Chailis, CMO Libertex Group
About Libertex
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